CONTEMPORARY MODELS OF DEVELOPMENT AND UNDERDEVELOPMENT
I. UNDERDEVELOPMENT AS A COORDINATION FAILURE
Coordination failure. A situation in which the inability of agents to coordinate their behavior (choices)
leads to an outcome (equilibrium) that leaves all agents worse off than in an alternative situation that is
also an equilibrium.
Complementarity An action taken by one firm, worker, or organization that increases the incentives
for other agents to take similar actions. Complementarities often involve investments whose return
depends on other investments being made by other agents.
When complementarities are present, an action taken by one firm, worker, organization, or
government increases the incentives for other agents to take similar actions. In particular, these
complementarities often involve investments whose return depends on other investments being made
by other agents
Examples of Complimentarity
Big push. A concerted, economy-wide, and typically public policy–led effort to initiate or
accelerate economic development across a broad spectrum of new industries and skills.
*which production decisions by modern-sector firms are mutually reinforcing
O-ring model. An economic model in which production functions exhibit strong complementarities
among inputs and which has broader implications for impediments to achieving economic
development.
* which the value of upgrading skills or quality depends on similar upgrading by other agents.
Middle-income trap. A condition in which an economy begins development to reach middle-income
status but is chronically unable to progress to high-income status. Often related to low capacity for
original innovation or for absorption of advanced technology, and may be compounded by high
inequality.
Underdevelopment trap. A poverty trap at the regional or national level in which underdevelopment
tends to perpetuate itself over time.
Deep intervention. A government policy that can move the economy to a preferred equilibrium or
even to a higher permanent rate of growth, which can then be self-sustaining so that the policy need
no longer be enforced because the better equilibrium will then prevail without further intervention.
*Such deep interventions move an economy to a preferred equilibrium or even to a higher permanent
rate of growth in which there is no incentive to go back to the behavior associated with the bad
equilibrium.
Congestion The opposite of a complementarity; an action taken by one agent that decreases the
incentives for other agents to take similar actions.
Examples of Congestion
Where-to-meet dilemma. A situation in which all parties would be better off cooperating than
competing but lack information about how to do so. If cooperation can be achieved, there is no
subsequent incentive to defect or cheat.
Prisoners’ dilemma. A situation in which all parties would be better off cooperating than
competing, but once cooperation has been achieved, each party would gain the most by cheating,
provided that others stick to cooperative agreements—thus causing any agreement to unravel.
II. MULTIPLE EQUILIBRIA: A DIAGRAMMATIC APPROACH
Multiple Equilibria. A condition in which more than one equilibrium exists. These equilibria sometimes
may be ranked, in the sense that one is preferred over another, but the unaided market will not move the
economy to the preferred outcome.
Pareto improvement A situation in which one or more persons may be made better off without
making anyone worse off.
III. STARTING ECONOMIC DEVELOPMENT: THE BIG PUSH
The big push model is a concept in development economics or welfare economics that emphasizes that
a firm's decision whether to industrialize or not depends on its expectation of what other firms will do. It
assumes economies of scale and oligopolistic market structure and explains when industrialization would
happen.
The big push addresses the problems present in multiple equilibria.
Assumptions of Big Push
a. There is only one factor of production – Labor
b. Workers in the traditional sector receive a wage of 1 (or normalized to 1, treating the wage as
the numeraire; that is, if the wage is 19 pesos per day, we simply call this amount of money “1”
to facilitate analysis using the geometry.
c. There are N types of products, where N is a large number
d. Each good receives a constant and equal share of consumption out of national income.
e. Economy is closed
f. Perfect competition in the traditional (cottage industry) sector is present, with free entry and no
economic profits.
Other Cases in Which a Big Push May Be Necessary
1. Intertemporal effects. Even if the industrial wage rate is 1 (i.e., the same as the traditional-sector
wage), multiple equilibria can occur if investment must be undertaken in the current period to get
a more efficient production process in the next period
2. Urbanization effects. If some of the traditional cottage industry is rural and the increasing-
returns-to-scale manufacturing is urban, urban dwellers’ demand may be more concentrated in
manufactured goods
3. Infrastructure effects. By using infrastructure, such as a railroad or a port, an investing modern
firm helps defray the large fixed costs of that infrastructure. The existence of the infrastructure
helps investing firms lower their own costs.
4. Training effects. There is underinvestment in training facilities because entrepreneurs know that
the workers they train may be enticed away with higher wages offered by rival firms that do not
have to pay these training costs.
WHY THE PROBLEM CANNOT BE SOLVED BY A SUPER-ENTREPRENEUR
First, there may be capital market failures.
How could one agent assemble all the capital needed to play the super-entrepreneur role?
Even if this were logistically imaginable, how would lenders have confidence in their investments?
In particular, how could a penalty for default be imposed?
Second, there may be costs of monitoring managers and other agents and designing and
implementing schemes to ensure compliance or provide incentives to follow the wishes of the employer;
these are often referred to as agency costs.
Agency costs. Costs of monitoring managers and other employees and of designing and
implementing schemes to ensure compliance or provide incentives to follow the wishes of the
employer.
Asymmetric information. A situation in which one party to a potential transaction (often a buyer,
seller, lender, or borrower) has more information than another party.
Third, there may be communication failures. Suppose someone says to you, “I am coordinating
investments, so work with me.” Should you do so?
Fourth, there are limits to knowledge. Even if we stipulate that the economy as a whole has access to
modern technological ideas, this does not mean that one individual can gain sufficient knowledge to
industrialize (or even gain enough knowledge about whom to hire to industrialize).
Finally, there is the empirical reason that no private agent has been observed playing the role of
super-entrepreneur.
IV. FURTHER PROBLEMS OF MULTIPLE EQUILIBRIA
1. Inefficient Advantages of Incumbency
2. Behavior and Norms
3. Linkages. Connections between firms based on sales. A backward linkage is one in which a firm
buys a good from another firm to use as an input; a forward linkage is one in which a firm sells to
another firm. Such linkages are especially significant for industrialization strategy when one or more
of the industries (product areas) involved have increasing returns to scale that a larger market takes
advantage of.
4. Inequality, Multiple Equilibria, and Growth
Poverty trap. A bad equilibrium for a family, community, or nation, involving a vicious circle in which
poverty and underdevelopment lead to more poverty and underdevelopment, often from one
generation to the next.
V. MICHAEL KREMER’S O-RING THEORY OF ECONOMIC DEVELOPMENT
O-ring production function. A production function with strong complementarities among inputs, based
on the products (i.e., multiplying) of the input qualities.
Implications of the O-Ring Theory
The analysis has several important implications:
Firms tend to employ workers with similar skills for their various tasks.
Workers performing the same task earn higher wages in a high-skill firm than in a low-skill firm.
Because wages increase in q at an increasing rate, wages will be more than proportionally higher
in developed countries than would be predicted from standard measures of skill.
If workers can improve their skill level and make such investments and if it is in their interests to
do so, they will consider the level of human capital investments made by other workers as a
component of their own decision about how much skill to acquire.
One can get caught ineconomy-wide, low-production-quality traps.
O-ring effects magnify the impact of local production bottlenecks because such bottlenecks have
a multiplicative effect on other production.
Bottlenecks also reduce the incentive for workers to invest in skills by lowering the expected
return to these skills.
VI. ECONOMIC DEVELOPMENT AS SELF-DISCOVERY
Information externality. The spillover of information— such as knowledge of a production process—
from one agent to another, without intermediation of a market transaction; reflects the public good
characteristic of information (and susceptibility to free riding)—it is neither fully excludable from other
uses, nor nonrival (one agent’s use of information does not prevent others from using it).
VII. THE HAUSMANN-RODRIK-VELASCO GROWTH DIAGNOSTICS FRAMEWORK
Growth diagnostics. A decision tree framework for identifying a country’s most binding constraints on
economic growth.
Social returns. The profitability of an investment in which both costs and benefits are accounted for from
the perspective of the society as a whole.
The Hausmann-Rodrik-Velasco Growth diagnostics framework
a. Growth diagnostics=decision tree framework for identifying a country’s most binding constraints
on economic growth.
b. Low returns to investors may be due to the fact that there are intrinsically low underlying social
returns to economic activities
i. Social returns=profitability of an investment which both costs and benefits are accounted
for from the perspective of society as a whole
c. Low social return causes:
i. Poor geography
ii. Low human capital
iii. Bad infrastructure
iv. Low appropriability
v. Government failures
vi. Market failures
vii. Micro and macro risks
viii. Coordination externalities
ix. High cost of finance
x. Bad international finance
xi. Bad local finance
xii. Domestic saving
xiii. Poor intermediation
Conclusions
a. people keep doing inefficient things because it is rational to keep doing them, and it will remain
rational as long as others keep doing inefficient things
b. The coordination failures that may arise in the presence of complementarities highlight potential
policies for deep interventions that move the economy to a preferred equilibrium or even to a
higher permanent rate of growth that can then be self-sustaining
c. The other edge of the sword, however, is that with deep interventions, the potential costs of a
public role become much larger
